This $226m money manager is betting big on small caps and consumer stocks

When I sat down with EFG Asset Management CIO Moz Afzal last month, he told me that he was taking this opportunity to add tactical risk into client portfolios. Afzal and his team have been buying equities across a range of geographies and taking bigger stakes in global fixed income. He was buying because he believed we had hit peak inflation.

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Well, if you use the US numbers as a benchmark, Afzal was absolutely right. But what he didn't reveal was that his team has been buying in many places Australian investors have been avoiding. 

In this wire, I'll take you through EFG's 2023 investment outlook which includes some brave calls and big contrarian investment ideas. 

But first - a caveat

Unlike other outlook white-papers, EFG Asset Management puts its money where its mouth is. Every analyst has a right to change their mind when the facts change but I've yet to see a firm admit their wrong calls as brutally as they do. Each December, the EFG team gets an external consultant to rate its big calls from the previous year. Afzal told me that the score is only received by the team and isn't influenced by them in any way. 

And after seeing this year's score, I'd believe that.

The 2021 outlook scored a passable 6/10 - a far cry from its long-run average of 8.3.

What did they accurately predict? The enhancement of globalisation and the fact that corporate earnings just wouldn't grow at the same rate as they did the year before. 

What did they get wrong? They missed the surge in commodities and - perhaps most egregiously - they thought inflation would be transitory. But they still want to issue a word of caution to monetary authorities around the world:

"The concern that interest rate increases will be seen, in retrospect, as a policy mistake still remains."

I will be interviewing EFG Asset Management's Chief Economist Stefan Gerlach in the new year. Gerlach is the former deputy governor of the Central Bank of Ireland and was a former member of the European Central Bank's Governing Council. 

If you have any questions for him, please send them to me: content@livewiremarkets.com

The top macro themes for 2023

And now you know that, let's introduce you to the EFG Asset Management team's 10 highest-conviction themes for 2023. 

Inflation (finally) subsides 

Inflation is still the topic de jour, but the big question is whether it deflates back to the target ranges of most central banks (usually 2-3%). The answer, in EFG's mind, is a big yes:

"On balance, the (misplaced) optimism about lower inflation in 2022 should be justified as 2023 progresses."

It adds:

"The US rate will be most closely watched. We see it at 3% by year-end."

Geopolitical tensions ease 

The invasion of Ukraine defined the rise (and partial fall) of commodities in 2022. The ASX energy index is up a lazy 43% in the past year with the broader resources index up a relatively paltry 19%. And while their call is for geopolitical tensions to ease, it's clear that Ukraine is the wild card.

"The biggest uncertainty relates to Russia, of course. Russia’s rehabilitation could start in 2023 if a solution to the war with Ukraine comes into sight."

Where they are seeing a thawing is in the Taiwan Strait, where they believe Beijing will have to focus on the national reopening instead of any plans to reassert its presence on the island. 

Global growth should moderate

A return to reality is the big macro theme for 2023 in their view, with China's reopening and India's acceleration likely to lead the charge. On the topic of a US recession, they don't believe there is one coming in their base case but if one does come, it'll likely be mild.

"After sharp gyrations in economic growth rates during the pandemic and its aftermath, 2023 will be a year when we return to reality."

Japan's economic renaissance continues 

In our November interview, Afzal noted the team was buying equities in Japan because of the accommodative central bank and the weak currency. After all, the Bank of Japan is continuing to pump that economy with stimulus given inflation has not been consistently in the target range for decades. But all that might be changing - and it's being led by the corporate sector.

"In recent years, corporate earnings in Japan have grown much faster than the overall economy. That trend will, we think, continue in 2023. It will be helped by the beneficial effects of the yen’s weakness in 2022."

Emerging economies recover (as do emerging market assets)

This is a story of sequence. Many emerging markets across Asia and Europe went into recession well before their developed counterparts. Now as those rate hikes start to take effect, inflation begins to recede and their currencies begin to regain some of their lost value.

Or so the theory should read. Enter China, which is (according to some) already in a recession even if the official figures don't show it. Should China recover from this recession next year, the EFG team believes 2023 could be a big year for emerging economies.

"After years in which emerging equity and bond markets have underperformed developed markets, we see 2023 as a much better year."

Weaker US dollar trend 

The US dollar has trended reserve currency. upwards for a decade and more. It reached overvalued levels in late 2022. Some say it was also the most overvalued and overbought trade since the Global Financial Crisis. Now it's receding, 2023 should be a year of correction for the world's reserve currency. 

Bond vigilantes on patrol 

Bond yields have been on nothing short of a rollercoaster this year but nowhere was that more apparent than the UK where the Truss/Kwarteng mini-Budget resulted in an almighty crash for the Pound as well as Gilt yields. If you missed that story, you can catch up here:

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But most of all, it proved that the vigilantes - or the threat sellers - were ready and waiting. And their presence means the bond market is not in for an easy ride next year.

"A broader concern is whether we now see a sustained higher level of real and nominal interest rates across all markets. Certainly, negative real rates on long-term government bonds were anomalous. The long bull run in bonds may, finally, be over."

And the top asset class calls for 2023

Investment-grade corporate bonds 

But just because sovereign bonds are in for a rough 2023 does not mean the same correlation can apply to corporate bonds. The case in point? EFG Asset Management believes corporate debt will be far more attractive than its government-denominated counterparts.

"We see investment-grade corporate bonds, notably in the US and UK, offering a better return/risk profile than either government bonds or high yield debt for 2023. Investment grade bonds rarely occupy extreme positions in the ranking of returns from different bond market sectors."

Global small caps 

EFG's team has two main reasons for calling out global small-cap outperformance next year. First, small-cap companies tend to be quicker at adapting to changing economic circumstances. And secondly, valuations are looking healthier. 

"Small cap companies are typically quicker to adapt to changing economic circumstances than larger companies, are attractively valued relative to large caps and have tended to outperform large-cap stocks over the long term."

The small-cap thematic is also in line with an important theme from 2022 - active investing wins out the day when volatility continues to be elevated.

Consumer discretionary sector

And now, the part that will really raise some eyebrows. Unlike most other investment houses, EFG Asset Management believes next year could be big for consumer discretionary stocks. Why? Because inflation is receding and that should help lighten the load on consumers. And given delinquency rates have remained low despite big concerns around consumer resiliency, they see no reason to doubt its potential outperformance.

"The trend is not confined to the US, so we would favour the expression of the theme on a global basis – but equally weighted - rather than market cap weighted so that the emphasis of mega-cap stocks is reduced."

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